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The Costs and the Benefits of Debt Consolidation
Is Debt Consolidation a good thing?
Some years ago, while working at a financial institution, I remember being very strongly opposed to the idea of giving debt consolidation loans to customers. While I am less antagonistic towards debt consolidation today, I still oppose the view that debt consolidation loans are a good thing. In our current economic climate, debt consolidation loans have become very popular and many financial institutions seem to be offering debt consolidation loans as a way out of debt. But is the consumer or customer really benefiting from debt consolidation loans? Here are my views about debt consolidation loans – the good, the bad and the ugly.
What is Debt consolidation?
First let me define what debt consolidation is. Debt consolidation is the method of compiling all your existing loans and getting a single, lower interest rate loan to pay off all those different loans. The main benefit of debt consolidation is the simplicity it offers by being able to deal with one single creditor (person/institution who you owe money) rather than having to deal with several different creditors who make no bones about harassing you about your late payments and your past due loan amounts. If you have ever had several debts outstanding and have to be constantly dodging phone calls from collectors, then you know exactly what I am talking about. It is not a pleasant situation. Debt consolidation makes it easier for you to handle your debt obligations.
The Bad and the Ugly of Debt Consolidation
Here are some of the reasons why I believe that debt consolidation loans may be a bad idea:
- You are paying interest on interest – When you pay off one loan with another, you are not only paying off the principal of the old loan, you are also paying off any accrued interest charges, late fees and other charges. With a debt consolidation loan, what you are essentially doing is paying interest on the interest already accrued on your past due loans. Here is an example. Let’s say that you have an outstanding credit card balance of $140 which includes the principal (original amount borrowed) of $100 plus accrued interest charges and late fees of $40 dollars. Let’s say that you decide to consolidate this credit card debt with your other outstanding debts by taking a larger loan of $1000 to pay off all the debts you have outstanding. When you pay off this $100 loan you will pay $140 which will clear off the debt completely. However, this $140 now becomes a part of the principal amount of the new debt consolidated loan. This means that you will now be required to pay interest on $140, not the original $100 that you had originally borrowed and were originally paying interest on. So instead of paying interest on $100, you are now paying interest on $140. As the loan term elapses, you will be accruing interest on $140, not on $100. With an interest rate of 10%, this means that instead of paying $10 in interest charges, you will now be paying interest of $14. At the end of the day, a debt consolidated loan is going to cost you more in interest charges (dollars and cents).
- You stand the chance of losing your collateralized assets – The majority of debt consolidation loans are secured loans. This means that when you get a debt consolidation loan, you are required to pledge an asset/(s) as security or collateral for the loan. If you run into problems and are not able to follow the payment schedule as agreed, the lender has the right to sell your pledged collateralized assets and to apply the proceeds to your outstanding loan balance. The implications are that you could lose your car or your house if you fail to pay according to schedule. You should be fully prepared to accept this possibility.
- You pay more interest over the longer term – Debt consolidation loans are normally structured over a longer term than the original loan terms. While credit cards normally have a 30 day term, debt consolidation loan terms can be as long as the lender will allow. What difference does that make? Remember that interest accrues over time. The longer the loan term, the more interest that will accrue on the loan. If you have a 2 year debt consolidation loan, it means that interest will be accruing on the principal for 24 months versus interest accruing over one month (30 days) in the case of a credit card.
Speak Up for Yourself
What is more important to you? Smaller monthly payments or less interest charges?
The Good, the Bad and the Ugly of Debt Consolidation
Lower interest rates
Interest charges 'capitalized'
Possible loss of Assets
Smaller monthly payments
Longer loan terms mean more interest
One creditor to deal with
The Good – Benefits of Debt Consolidation
There is a reason why debt consolidation loans are so popular. They do offer some benefits to the borrower and these benefits make the product attractive. Here are some of the benefits of debt consolidation.
- Lower rates of interest – Because debt consolidation loans are usually secured, you are usually able to access such a loan at a lower rate than your original unsecured loans (such as credit card balances). This means that in percentage terms you are paying less interest. Whereas your credit card rate could be as high as 49% per annum (yep, I actually had credit cards with rates of 49% per annum), debt consolidation loans usually have significantly lower rates.
- Longer loan terms mean smaller monthly payments – You will get more time to pay off your debt consolidated loan than the time you had to repay your original loan. This usually makes it more affordable for borrowers. For example if you originally had 5 debts with monthly payments of $70, $150, $40, $15, and $60 totaling $335, a debt consolidation loan may require you to make a monthly payment of only $100, ‘saving’ you $235 per month.
- Only one creditor to deal with – Nobody likes being harassed by creditors. With a debt consolidation loan, you will have the opportunity to reduce the number of creditors you have to one single creditor. This should not only give you greater peace of mind, it should allow you to be able to better manage your finances since you have fewer borrowers to whom you are obligated.
At the end of the day debt consolidation loans offer a solution to borrowers who are overwhelmed with debt. However, the decision to take such a loan should include thorough analysis of the long term implications of entering into such an agreement. Debt consolidation loans are not a way to ‘save’ money, but are rather a way to more easily manage your debt obligations. While there are real benefits to debt consolidation, there are also real costs.